It must be lonely being a China bear….particularly for those dubious about its longer term prospects, as opposed to those who might simply think its stock market is a bit ahead of itself even after its recent correction.

Vitaliy Katsenelson, in an article at MorningStar, beings almost sounding a tad persecuted before he warms up to his theme. that there is more in common between Japan in the late 1980s, when it seemed poised to continue its inexorable rise and China today. And the differences for the most part favor Japan. Katsenelson first quotes Jim Grant at length, then offers his own comments.

China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot)…Today China projects to the world a similar image as Japan did in the 1980s…

Lately, the Chinese economy has been impressing us with its growth…But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending.

However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is. I’ve written a lot about this (here and here). Instead I’ll quote James Grant, the publisher of Grant’s Interest Rate Observer. Jim is providing the latest issue of his newsletter free…Here are a few quotes …:

“A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”

I think this chart, also excerpted from Grant’s Interest Rate Observer, tells the full story of the quality of China’s latest growth…

“Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember … Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’ Drexel failed when the junk market did.

Yves here. Hyman Minsky fans will recognize this as his Ponzi unit paradigm. Back to Grant via Morningstar:

“Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.” [emphasis is mine]

Yves here, I know extended quotes in blog posts can be a bit confusing. We are now done with Jim Grant and are back to Katsenelson in a second of two linked articles:

Today, Chinese economic growth is the force pushing the global economy. The quality of this growth, however, is low as it is predicated on massive (forced) lending and thus unsustainable. As Chinese growth slows, China will turn from a wind into sails of global economy to its anchor. The impact will be felt in many, often unsuspected places.

It will tank the commodity markets, commodity producers and commodity exporting nations. Let’s take oil, for instance. As incremental demand from China collapses, oil prices will follow, taking the Russian economy with it, as Russia is for the most part a one-trick-petrochemical-pony. According to GavKal Research China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation..

Demand for industrial goods will fall off the cliff. China consumed a lot of those goods – $550 billion worth annually (also according to GaveKal Research). So if Caterpillar expects to sell more of its yellow earthmovers to China, it will have put that thought on hold for awhile…..

Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5% mortgages and 6% car loans.

Identifying bubbles is a lot easier than timing them. An astute observer could have seen the Japanese bubble developing in 1986, 1987 and 1988, but he would have been “wrong” until 1989….

Yves again. The other reason to take this gloomy appraisal seriously is that in the Great Depression, it was the big exporter (the US) that faced the most difficult adjustment. Overconsuming indebted countries in Europe simply defaulted.

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23 comments

Myself, I doubt that the historical comparison—China 2009 : Japan 1989—is a particularly good one; it may well even be an invalid one. A few points.

Japan in 1989 was a mature industrial country. China in 2009 is nothing like a mature industrial country; there is much room for expansion, and a good measure of the 'industry' is comparatively low-value assembly with significant overcapacity (now being sharply contracted).

Japan in 1989 had an extensive financial sector, with a large and liquid stock market. China in 2009 has a financial sector small not only in relation to the country but even moreso in relation to the global economy. The stock market is narrow, small, and immature. Both depend _heavily_ upon the state for funds and 'guidance.'

Japan in 1989 was an urban-dominated society with a very large middle class, though one not very liquid or wealthy. That middle class saved relentlessly, creating a sizeable pool of assets nationally. China 2009 is still (still) primarily a rural country. The middle class is tiny compared tot he population as a whole, if increasingly potent because connected to the global economy. Still, the asset base of that tiny middle class is small in relation to the economy. In many respects, the pool of rural capital is much more important to China's domestic economy than the pool of middle class urban capital; that is my surmise (though I'll say that the issue is debatable, and in fact would benefit from closer study by someone).

One could go on, but the main point I'd make is that this just isn't a good historical comparison. One more accurate would be comparing Japan _1959_ with China 2009. That is much closer. And independent of broad comparative issues, I'll say also that from the cyclical standpoint this is much, much closer to a true comparison. For one thing, this represents both national economies at comparable places in the innovation cycle: we should be anticipating a _significant_ innovation boom in China. [Note: The most accurate cyclical comparison would be Japan 1949 to China 2009, but the post-war devastation in Japan suppressed output and skewed society in a way that distorts more than it reveals. Try, then, Japan 1955 or so for an optimal placement.]

Most doing economic or political reasoning don't do historical comparisons. It follows then that when they do do them, they don't do them well. When making historical comparisons, the typical, understandable, if unfortunate approach is to seize upon a salient similarity in two contexts and then propose comparable outcomes. "That's history, right?" Hmmm: not so much. One has to compare the _entirety_ of two contexts, or as much as one has time for, because small differences at the margins often prove to be, well _not_ small, and furthermore they often have significant effects in how systemic relations form. One has to compare _systemic relationships_, not simply salient features. This is obvious when one considers it, but seldom pursued in practice. Few historical contexts are highly analagous but broad comparisons winkle out the best matches as opposed to evident but in fact specious correlations.

For example, we very probably would have had a housing bubble in the 2000s under almost any scenario. Why? Well, we already had a smallish bubble under way in the 1990s, certainly on the coasts where housing prices departed historical linkages with incomes in those regions, the definition of a bubble event horizon. And then too, we _had_ a housing bubble in the 1980s on a regional basis: it burst (y'all 'member the Savings and Loan Crisis . . . No?). But nothing in the housing process really changed. The credit enablers of that moment busted out, but the industry dynamics were unreformed, hence the stirring bubblet from 1994. —But what was a bubble turned into an engulphing tumor when Alan the Greenspender smiled fondly on the colossal credit creation of the shadow banking industry. So any historical comparison for the US 2000s _has_ to have a comparable pyrotechnical credit creation component. Fair ones would be Argentina of the 1990s, when regional banks lent stupendously beyond any possible reserves or collateral with the connivance of the govenrment of their time. ('Member Menem? I thought not, but.)

I stress all this having read a few hours ago Paul Krugman's explication of his sanguine view of the blooming US Guvmint deficit. Now, Krugman is undoubtely correct that the main hew and cry against a projected $9T deficit is from radical conservatives on entirely political grounds with no economic validation. But in making his point, Krugman makes an historical comparison, that of the US 2009-19 to the US of, say, 1949-59 (he doesn't make his dates specific). He chooses these periods because he projects a similar debt to GDP ratio for the US in both, pointing out, correctly, that the US was carrying _a lot of war debt_ well into the Fifties. But despite that salient feature this is not a particularly apt comparison.

US in 1945-49 had a huge pent up demand for housing and consumer goods, especially automobiles. Even if we saw a projectible bounceback of demand in the US 2009-19, it would in no way be comparable. Then too, consumers of today are severely debt-ridden. Those of 1945, by contrast, had little debt, and in fact those who had worked on the home front often had cash pools to put to work. The global economic situation of the US 1949 and 2009 are very different, as was mentioned in comments to his blog post on this; so different that I needn't detail them. The demographics of the US in the two areas have significant differences, and while the economic impact of these discrepancies would need analysis they are likely of some significance to their overall similarity: Similarity cannot be assumed here, it must be demonstrated. So the first point is the historical comparison is far less apt then one, putatively comparable feature.

Then there is the issue of how accurate GDP numbers _are_ in 2009 compared to 1949. I'm far less comfortable in just stacking the numbers side by side given the manipulation of current figures than Krugman is. This may be a minor issue but the fact that it doesn't enter into the discussion is not. Also mentioned in comments to his post, present US debt is becoming highly short term, a real problem, whereas post-war US debt was substantially of the 30-year variety, where inflation could, and very much did, work its magic. So again, the historical comparison erodes at its edges in ways that substantiall undermine its validity.

But finally Krugman goes on to project for the US 2009-19 a 2.5% growth rate and a 2% inflation rate. He has some basis for his assessments there—but his principal basis is the historical comparison. Without that prop, those projections are highly debatable. And I'll say that I find them wildly high in relation to the context we have as of 2009. I would not be as sanguine regarding the debt levels going forward as he is. They may not be fatal, but they are more than worrisome. And the historical 'comparison' which shows them as tolerable has no traction so lends even less solace, to me.

To add to Richard's analysis, what I was thinking while reading Krugman's posts is that in the 50s oil discovery and production were briskly rising, while today they have been basically stagnant since 2005, and their decline is highly likely to be exacerbated within five years as the delayed effects of the credit crunch, all the postponed or cancelled oil projects of the past year, come to bear.

We need to remember that just as the finance sector is just an epiphenomenon of the real economy (or SHOULD BE, though its current revenue share and politcal power are obscenely out of all sane or moral porportion), so the real economy is dependent upon cheap, plentiful oil.

This has to be taken into account in any comparison of the coming decade with any past events.

A quote in the post mentions oil prices as a factor, though doesn't delve into the looming fundamental supply crunch.

So Purple, agreed with regard to the Plaza Accord. At exactly the point the Japanese needed to retrench, consolidate their gains, and fix some longstanding flaws they instead did just the opposite: they locked in their currency at a highly distorted number that all but guaranteed a speculative bubble. Got one, too, which shot their banking system full of paralytic shellfish toxins and organ-killing fungi.

Now I can think of some present comparables for _that_ matrix (which is not your point,here)—but not in China. They may be getting bubble-lets, but compared to the size of their economy these are nothing linke Japan 1989. Furthermore, they are getting bubblelets in a deflationary context, not the same as Japan >>>1989, either.

Purple: "I think when people compare Japan and China they are mostly talking about them being export dependent, and covering bad loans through heavy exporting." I think you assess the general remark well here, and I would agree that both countries use exporting to cover their bad loans as an explicit strategy.

However, it simply isn't true that China is 'export dependent.' I wish folks would _stop_ repeating that canard. The Chinese domestic economy is much larger than their export numbers, even though it lacks (as an explicit policy choice) a robust consumer demand segment. Seven-ten years ago, this (mis)assessment had more the ring of truth. Now, no, and even less so in that such stimulus as China is delievering is going not to exporting bric-a-brac but pushing domestic construction and investment (badly one might add, the thrust of truth in the analyses mentioned in Yves' post).

The primary reason, to me, why analysts continue to misunderstand China's prospects is exactly that too many continue to convince themselves that China 'is export-dependent.' To me, this reasoning is fundamentally politcal but often, I think, not explict in the thinking of the speaker. Simply because China is using exports to generate industrialization and its financial system, as did Japan and Taiwan amongst others, it is inferred that it must therefore be 'export dependent and mercantialist' since both other countries were (and are). Exports are only half the story, though; the smaller half.

It was 'reasoning' of this kind in the analyses included in the post which first stirred my misgivings regarding their conclusions. And if you were all following the bouncing conclusion, no, one cannot select apt comparisons when the initial perspective of the context to be matched is fundamentally skewed.

Comparing China with Japan is a bit off the mark. I see it as driving in the rea view mirror.

The excessive inquiry into prior experience is looking at the wrong clock. The best estimates of future perfromance are found in an analysis of the current conditions and performance that imply the establishment of forthcoming conditions.

Viewed that way, it is reasonable to expect that China will soon have a debt problem to deal with.

I'm not so sanguine about Chinese domestic growth. Domestic growth there is driven by investment, but Chinese investment has been very bubblish for years, producing a massive oversupply of deluxe high-rise condos that are now sitting empty. Steel production capacity has soared this year even though production remain well below *last* year's capacity. Massive investment into probably unusable industrial capacity indicates a seriously deranged financial system. So I think the Japanese comparison is very apt as the Japanese bubble had a huge component in investment that also turned out to be pretty useless.

So Dan Duncan, I'm a tad hurried so I don't have time for a real reply, but, a) I _do not_ agree tha comparisons are useless, and b) . . . did you actually read anything I wrote? I mean, did you _think about_ anything I wrote? It's not obvious that that occurred.

I had a lot to say after reading this post…until I saw Richard's fine responses. I did comment to Krugman's blog on the historical comparisons issue. I think Richard nailed it, for the most part. The comparisons are of little value, but at least we can argue about which comparisons stem from higher equivalence in the more relevant facts.

Quick sum…they are of little value, not no value.

FWIW, China 2009-Japan 1989 does seem a tad outrageous to me, but I can admit that's because I place great weight on productivity, population constraints, size of financial sector, real estate prices, and relative per capita GDP across nations. In the end, those may not be the critical factors in how China fares in the next couple decades. I can't predict the future. We shall see.

China's miracle growth economy is another fabrication generated by the financial media to be added to other similar stories. The big loser is the American taxpayers now providing the backstop for the financial sector and allowing those responsible for gutting our manufacturing base to be replaced by retail and information service jobs a continued free ride.

I think wider point is how far past equilibrium China has gone and how serious the consequences of a reblance will be on the world economy. there has been no systemic correction in the imbalances inherent to the development model that china still espouses. quite the opposite, they have accelerated their investment in deflation/overcapacity at the expense of their vastly more efficient private sector.

and as grant points out:

"“In the 1930s, Western intellectuals persuaded themselves that the Soviet economic model was depression-proof. Today, not a few investors marvel at the vigor of the modified communist economic model of the People’s Republic.""

richards points are well taken…the detailed means that china and japan used to achieve their respective imbalances were different.

But i think yves is trying to say that, what they did share was accrued imbalances that represented systemic risks to their mercantilist futures.

but as the post points out, China's rebalance will have a much more profound (negative) effect on worldwide GDP than did japan.